Find below an excerpt from a fascinating Morgan Stanley study of the global supply of commodities by investment banks. Nice job if you can get it. Trade the commodity and control the supply. Rent-seeker 101.
The long-awaited unwinding of inventory financing and trading deals in LME metals appears to have begun, in our view. Ultimately, we expect a number of wash-back effects, the most important of which are likely to be renewed price pressure on aluminium and zinc, as well as second-order effects on some feedstock prices such as alumina. We think copper prices should escape any significant near-term pressure, but more ready access to metal over time could be negative as supply increases.
Recent developments driving change: The combination of the recent increase in regulatory scrutiny of Financial Holding Companies (FHC) participation in physical commodity businesses, changing LME rules on warehouse load-out rates, and rising global interest rates has focussed market attention on the possible demise of warehouse-based trades. This story has its roots in three developments since the Global Financial Crisis of 2008-09: 1) An extended period of very low interest rates and unconventional monetary policy via Quantitative Easing (QE); 2) the rapid consolidation of LME warehouse ownership and the subsequent geographic consolidation of metal in warehouses, and 3) increased regulatory oversight of FHCs in the US following bank failures and the injection of large amounts of taxpayers’ money in 2008 amid increased concern about systemic risks to the banking system.
Origins in the Global Financial Crisis
To appreciate the significance of changes that are under way, it is worth recalling that the factors now heralding important changes in the physical metals trade and warehousing businesses of the LME have a common origin in the Global Financial Crisis of 2008-09.
As the LME Board itself noted in May 2011 in response to the report and recommendations of the Warehouse Study by Europe Economics, in 2009 the North American aluminium industry was facing a major recession with the apparent collapse of major automotive customers. “At that time the concerns of the industry were all centred on the need to deliver material into a warehouse, with dire warnings about the consequences for the LME should there be a capacity constraint that affected the free flow of surplus metal onto warrant. We now find that the major concern of that same industry (and in some cases the same participants) is the ability to take material out of warehouse. We also note that the situation has been exacerbated by the coincidental availability of surplus aluminium with the widespread policy of central banks holding down interest rates and creating a pool of cheap money that increases the attractiveness of financing deals and in turn increases the pressure for fiscally motivated stock movements.”
Warehouse ownership the key
While the LME’s assessment of the origins of the problem of lengthening exit queues and their impact on the aluminium market addressed many important aspects of this issue, a notable and persistent omission from their analysis has been a consideration of the impact of warehouse consolidation on the growing problem of lengthening load-out times. Yet this
problem of lengthening warehouse queues and elevated premium structures has emerged as part of far-reaching changes in the ownership, control and distribution of the LME warehousing business.
Most important in this respect have been the material diminution of independent warehouse ownership since 2010 and the resultant significant concentration of warehousing business in the hands of banks and larger trading houses. This development also had its roots in the global financial crisis when JP Morgan Chase acquired the physical commodity
assets of Bear Stearns in 2008 and in 2009-10 the warehousing and physical commodity trading assets of RBS Sempra under the brand name of Henry Bath & Co. While significant in the context of today’s heightened regulatory oversight of FHCs, the real trigger event for LME warehouse consolidation appears to have been Goldman Sachs’ acquisition of Metro International Trade Services LLC, a leading global warehouse operator specializing in the storage of non-ferrous metals for the LME. Incidentally, Metro was also the largest warehouse owner in Detroit, and effectively dominated this LME good delivery point at the time of the surge in demand for warehouse space in 2009.
As has subsequently become clear, domination of a good delivery point through the ownership of the majority of multiple warehouse units licensed to receive a particular metal in a given location is a necessary condition for controlling metal inflow, outflow and associated rental cash flow that is the foundation of warehouse rental and financing deals. In addition, a sizeable balance sheet and an active involvement in physical trading as a means of engaging in inventory finance or warehouse incentive deals became a sufficient condition of this domination.
Not surprisingly, the lessons and opportunities provided by the Metro acquisition were not lost on the big physical commodity trading houses, which, in a short space of time from March 2010 onwards, bought the majority of the remaining independent LME warehousing businesses. The most important of these acquisitions were Glencore Xstrata’s purchase of the Pacorini Group, Trafigura’s acquisition of North European Marine Services (NEMS), the Noble Group’s
purchase of World Wide Warehouse Solutions (WWS) and Louis Dreyfus Commodities’ acquisition of GKE.
Because of these ownership changes and a small number of subsequent deals, “the number of independent LME warehousing companies has accordingly steadily declined to around 35 per cent of the total as of July 2013,” according to Thomson Reuters. In this process, with the notable exception of the C.Steinweg Group, most of the remaining independent LME warehouse companies have become small and location-specific operations.
Concentration of metals storage space
However, changes in the LME warehousing business were not confined to ownership alone. The emergence of bank- and trading house-owned warehousing and logistics businesses subsequently triggered a simultaneous expansion of licensed warehouse units that magnified the effects of the ownership changes that had taken place in 2010. According to Thomson Reuters, the number of LME-registered warehouse units increased from 584 in March 2010 to 678 in mid-July 2013. The current level of registered units is actually slightly below the absolute peak of this development, which was in August 2012 at 689 units.
In this process, not only have warehouse units controlled by small independent companies continued to decline relatively and absolutely, but also there has been a growing concentration of locations with an increasing number of units controlled by banks and warehousing companies. The increase in bank- and trading company-owned and -controlled warehouse units has largely been in five notable LME good-delivery points: Detroit and New Orleans in the US, Antwerp and Vlissingen in Europe, and Johor in Malaysia.